Heading for the overvaluation vortex

However, even allowing for irrational exuberance and for a large investor base with lots of cash to spend, I think there’s more to it than simply funds flows.

The real bet that people are making by investing in A-shares is that China will become a civil society ahead of expectations. This has material implications for rule of law in business dealings, for corporate governance, and for shareholders’ rights.

Local analysts’ forecasts of over 25% earnings growth in 2007 – while perhaps on the optimistic side – are now beginning to see some basis amid 2006 performance. Profit figures paint a positive picture of China’s industrial enterprises, showing their ability to weather the harsh environment of 2005 by making internal changes to boost productivity.

While the first three quarters of 2005 saw 75.6% growth in the profits of upstream industrial firms, the growth decelerated to 33.6% in the first three quarters of 2006, reflecting slower growth in commodity prices and a higher base from 2005.

Moving downstream

Midstream and downstream industrial profit growth has taken up the baton, rising from single digit growth figures in the first three quarters of 2005 to 18% growth for midstream companies and 39% growth for downstream companies in the first three quarters of this year.

Food & beverage businesses saw profits rise 31.4% in the first three quarters of 2006; for utilities companies it was a 36% rise, up from 19.1% profit growth in the same period in 2005, reflecting the flow-through of tariff increases.

The prospect of strong corporate growth in 2007 is the good news. The bad news is everyone else has the same idea. Add to this the fact that growing openness of China’s capital markets attracts international investors – many first-timers – and you have the makings of a stock market rally which will stretch conventional valuations.

Market sources guesstimate that around RMB450 billion (US$57.2 billion) is available from institutional investors, while demand for funds is unlikely to exceed RMB370 billion (US$47 billion), leaving an excess which may find its way into higher share prices. This amount is small relative to the market cap of RMB5.1 trillion (US$647.9 billion) but does not count substantially larger local retail funds which can return to the market at the click of a keyboard.

The good news for us is that although a lot of people are catching the A-share bug, we got there first. Our favorite steel stock, Baosteel 600019, rose substantially beginning shortly after our last publication date, lifting itself from the doldrums in the RMB4.30 range up to a high of RMB5.80.

Not to be outdone, Huaxia Bank 600015 has climbed steadily, rising to around RMB5.3 and justifying – I hope – our aggressive call on the bank. There is something of a rush into bank stocks at present which has perhaps left us ruing our decision to jettison Bank of China 601988 last month. It has risen back to our original purchase price but no further, but it’s possible growing interest in the bank’s H-shares could have a knock-on effect.

Overpriced banks

Chinese banks are trading at fairly astronomical price to book valuations, with China Construction Bank’s H-share trading at 3.25 times book, and Bank of China’s H-share trading at 3.53 times book. Compare this to HSBC, a global integrated bank with exposure to China, trading at 2.3 times book in Hong Kong. Remember also that these are rational international investors in Hong Kong paying these prices!

Huaxia’s price to book is an undemanding 2 times – a steal compared to its larger cousins. We’ll hold on to this one as well; it looks like it still has legs.

Inner Mongolia Dairy producer Yili 600887 has had an up-and-down month as a sharp rise was followed by an equally sharp fall, sending the share price well below our purchase price of RMB19.81. The local press indicates that the tuss-up seems to be the result of fund managers punting the stock. Again, we’ll hold this one.

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China Economic Review (CER) has been a dependably independent voice on trends and developments in the greater Chinese economy for a quarter century. Our coverage has won recognition from the Society of Publishers in Asia and is widely read by economists, business leaders, academics and students with an interest in one of the world’s most vibrant and complex developing markets.